A rotation opportunity in tariff-driven volatility

Jeremiah Buckley: If the tariffs stay as they’ve been announced, it will certainly have an impact on the overall economic environment. We believe that it could lead to lower real GDP growth and then a higher contribution to nominal GDP growth from higher inflation.

Now the market and a lot of the rhetoric and commentary has been that this is going to lead to a recession. I think there’s a long way between the economic growth that we’re seeing today going into this announcement and a recession.

And the reason for that is about 20% of U.S. GDP is consumer spending on goods. That’s broken up between about 13% is spent on nondurable goods, and most of those goods we produce internally in the United States. But there are some, like clothing and accessories, that we do import, and so prices will be impacted in that part of consumer spending. The other piece, 7%, is durable goods – think autos and furniture – and certainly tariffs will have a dramatic impact on the cost for those items.

On the other hand, consumer spending on services is more than double what we spend on goods. And as a result of this, there should be some follow-on effect, some at least moderate impact on inflation and consumer services as well, but it’s not going to be as dramatic. And so, as you look at the whole of GDP, just this one portion of import goods being tariffed and raising costs as well as driving higher inflation, I think is only one piece of the puzzle, and that we have to consider all of the other contributors to GDP as well.

There’s also a number of offsets that could make the impact on GDP less than the original forecast of isolating just the impact of tariffs. And included in that is we could see changes to trade terms post this announcement. And then secondly, energy prices have come down; that would be good for consumers. That would also be good for companies as well, and their cost basis as material costs come down.

We could also see movements in currencies, and companies also will adjust to this new environment, new cost environment. They can adjust where they manufacture goods and source goods. Companies can also adjust with re-engineering product.

And the last being, you know, the impact on interest rates. If we’re assuming that there’s going to be a recession, we should assume much lower interest rates. And so other parts of the economy that are more exposed to lower interest rates could also offset some of that impact of a higher cost of goods.

We’ve had a very severe response to this news, and we certainly agree that we should be lowering earnings estimates as a result of this, as a result of our changed economic view.

But our argument is that the market could be more than compensating for what the actual earnings reduction should be. And part of it is, it’s still to be determined whether the impact to GDP will be as severe as forecasted.

Our analysts are spending time in their models altering their forecast based on these adjustments to the environment. And we don’t believe that the earnings impact warrants what the stock price movements have been at this point.

We could be close to the worst of the sentiment as well. The administration has talked about their policies around tariffs, around tax policy, as well as around regulatory reform. And certainly, the tariff piece was the most negative piece from a market and a corporate earnings standpoint, whereas we still have those other pieces of the administration strategy and policy to come.

Periods of extreme volatility like we’ve been in the last couple weeks and the last month and a half really gives us as active managers a lot of opportunities to add value by actively managing positions as well as industry exposure.

The S&P telecom services is up 15% so far this year, whereas semiconductors are down nearly 30% so far this year. And so that’s a great example of the severe rotation that we’ve seen to defensives and away from growth cyclicals and secular growth companies. And so as active managers, we get really excited about the opportunity to take advantage of these rotations.

We believe over [the] long term, secular growth drivers are far more powerful in driving stock returns than the short-term macro fluctuations. And so we’re seeing lots of opportunities in secular growth companies, that for the last couple of years, we haven’t wanted to invest in them because the multiples were above what we thought were reasonable prices to pay for these businesses over the long term.

The companies that are going to be most resilient are the companies that have global scale that don’t have to take significant price increases in one region of their business because of higher costs as a result of tariffs, but they can spread that out globally. They have the ability to adjust sourcing, and they have the ability to work with suppliers to partner to find ways to reduce cost, to offset the higher cost from tariffs. Those are the companies that we think can extend their competitive advantages in more challenging periods like this where we have a change in the overall conditions within the operating environment.

Given the volatility that we’ve seen and the significant difference between returns in different asset classes, it really shows the benefit of being active and having the flexibility to invest in multiple different asset classes, whether that be fixed income or equities.

You’ve seen the benefit of having fixed income as part of multi-asset strategies. It’s provided that ballast and provided more consistency of returns, and it’s done its job in providing that negative correlation to what equity returns are in periods of uncertainty, like we’ve seen.

As we do our analysis on the impact and model the impact on macroeconomic fundamentals like GDP and inflation; that gives us an informed view on how to position strategies between the various asset classes based on the risk and reward that we see.

And also in looking at equity specifically, having an analyst team that is able to model the differences in the environment on a short-term basis, looking at the impact to overall earnings and the impact of their long-term growth assumptions, and then marrying that to what the market impact or the market reaction is to this macroeconomic news gives us an opportunity to define companies that we want to invest in for the long term that are dislocated in the short term because of this short-term noise and changes in policies and the expertise to analyze the impacts of that over time gives us an advantage in identifying those companies that we think will recover once we get into a more normal environment.